This post on what I call the FMV/Stout Restricted Stock Study is the eighth in a series looking back on the various restricted stock studies that appraisers have relied on for years. The series questions that reliance, for sure and would make excellent training material for younger and older appraisers. The prior posts in the series are linked below for reader convenience.

The previous posts in the series include:

• Deja Vu #1: SEC Rule 144 (Pre-1997) as Background for Restricted Stock Discounts
• Deja Vu #2: The SEC Institutional Investor Study (Published 1971)  (Average Discount = 26%)
• Deja Vu #3: The Gelman (1972) (Average Discount = 25%) and Trout (1997) (Average Discount = 34%) Restricted Stock Studies
• Deja Vu #4: The Moroney Restricted Stock Study (1993) (Average Discount = 35%)
• Deja Vu #5: The Maher Restricted Stock Study (1976) (Average Discount = 35%)
• Deja Vu #6: The Silber Restricted Stock Study (1981-1988) (Average Discount = 34%)
• Deja Vu #7: The Mandelbaum Factors and “Benchmark Analysis”

Introduction

Stout acquired FMV Opinions, Inc. in 2017 and the FMV Opinions database with the acquisition. Now, the Stout Database continues, and restricted share issuances are added as they occur. For clarity, this post refers to the Stout/FMV Database, which is available on a subscription basis through Business Valuation Resources. At the present time, the FMV/Stout Database contains information on 751 transactions.

My 2005 book, Valuing Shareholder Cash Flows, included a restricted stock study based on the 430 transactions in the FMV/Stout Database as of 2004. The Mercer study examined the 248 transactions in the database that occurred prior to April 28, 1997, and also examined the 182 transactions in the database that occurred after that date. This analysis focused on the pre-1997 transactions (the two year analysis) when the SEC Rule 144 base period of restriction was two years. We note some results from the post-1997 transactions (the one year analysis) for perspective.

Initial Observation. One could, of course, observe that the study analyzed in this post was performed in 2005 based on transactions occurring through 2004 and is therefore not current.

However, there have been no new pre-1997 transactions since 2004.

The one-year portion of the study has grown from 182 transactions in 2004 to some 500 transactions currently, or an increase of some 321 observations. For perspective, that’s about 18 transactions per year since 2004, all of which are in the one-year restricted period or shorter, given other changes in SEC regulations since April 1997.

The analysis was valid in 2005 and is valid today, at least in my opinion.

The FMV/Stout Database and Time (per the Mercer 2005 Study)

The FMV/Stout Database, as noted above, is divided into a two year study period, during which the SEC Rule 144 period of restriction was two years (until April 29, 1997), and a one year study period containing transactions occurring after the change in Rule 144 to a one year period of restriction. Transactions in the two studies occurred as follows in Exhibit 8.16 (exhibit references are to Chapter 8 of Business Valuation: An Integrated Theory Third Edition):

The majority of the transactions in the two year portion of the FMV Database occurred in the 1990s. The majority of the transactions in the one year portion of the study occurred before the meltdown in the market following the tech boom period. No transactions were reported in the database between 2001 and May 2004.

Observation 1 – Lack of Timeliness. It would seem that the use of transactions from the FMV Study as a direct guideline company or guideline transaction occurring 25 or more years ago would not meet the customary standard of proximity to the valuation date for appraisals as of the current date.

The FMV/Stout Database and Industry

The FMV/Stout Database can also be stratified by industry classification. One available data point is the four-digit SIC Code for the issuer in each transaction. Exhibit 8.17 summarizes industry groupings in the FMV/Stout Database.

For purposes of this review, we sorted the transactions by two digit codes. In the two year portion of the database, nine industry classifications account for 185 (75%) of the 248 total transactions. The remaining 63 transactions are spread over 25 other industry categories. Interestingly, of the 28 transactions in SIC Classification #28, 18 represented companies in SIC Code #2834 (pharmaceutical preparations). Of the 24 transactions in SIC Classification #87, 15 are in SIC Code #8731 (services, commercial, physical and biological research). The two year portion of the FMV/Stout Database is concentrated by industry.

The one year portion of the database is even more heavily concentrated in a few industry sectors. More than 75% of the 182 transactions occurred in only five two digit SIC classifications.

Observation 2 – Limited Industry Representation. There is little industry diversification reflected by the companies involved with either portion of the FMV/Stout Database. This fact limits the usefulness of this restricted stock database as a vehicle to develop guideline transactions similar to the subject private companies in terms of industry.

Overall Averages of the Studies

We begin with a summary of the overall medians and averages for the FMV/Stout Database, looking at both the two year and one year portions of the database. They are reflected in Exhibit 8.18.  Three discounts based on three pricing dates are shown in the table. Discounts were calculated relative to prices from the month prior to issuance, the transaction month, and the subsequent month. Based on articles and speeches by employees of FMV Opinions at that time, the primary focus was on subsequent month pricing, which will be our focus after Exhibit 8.18.

The median and average discounts (SubMo) were 22.0% and 22.5% for the two year portion of the database. The standard deviation was 21.5%, indicating the variability of the observed discounts.

The one year portion of the database had median and average discounts of 23.0% and 20.7%, respectively. Interestingly, the standard deviation of discounts in the one year portion was 35.2% higher than that in the two year portion. Note also that the post-1997 transactions with a shorter period of restriction had somewhat higher average discounts than the two year transactions. This caused consternation among some appraisers who knew, based on common sense, that the shorter expected holding period transactions, other things equal, should have had lower discounts since they had less risk of exposure to illiquidity.

This apparent anomaly is most likely attributable to the changing nature of companies issuing restricted stock in the post-1997 era. They were smaller, less profitable, more volatile, and riskier, on average, than the companies in the pre-1997 group.

Observation 3 – Observed Discounts Carry no Economic Information. The averages and medians of the FMV/Stout Study are just that – averages and medians. They convey no economic information at all, as explained in a prior series on restricted stock discounts in RSD-1: Background on Restricted Stock Discounts.

Quintile Operating Analysis of the Two Year Portion of the FMV Database

Next, we examine the transactions in more detail to understand the operating nature of the companies involved and relationships that may be discernible with respect to operating characteristics and restricted stock discounts.

To do so, we divided the two year transactions into six groups. We segregated all transactions that occurred at premiums (i.e., negative discounts) and then divided the remaining transactions into quintiles (five groups of equal size). We made the premium adjustment because there are apparently different forces or factors at work with those transactions and we found it helpful to examine them separately. The quintile analysis for the two year group is shown in Exhibit 8.19.

We focus on the 248 transactions occurring during the time when the SEC period of restriction was two years. In the upper left, we see that 23 of the 248 pre-1997 transactions occurred at a negative discount (i.e., at a premium to the market price of the issuing companies) with a median premium of 5.4%. Premium transactions can occur because the purchase price was set at a premium to the market price, or because of a decrease in the stock price between the announcement date and the subsequent month pricing in the FMV Study, or both. We do not really know the reasons for premium transactions, so they are treated separately.

The remaining 225 transactions were divided into five quintiles of 45 transactions each. As indicated in the top-middle of the table above, the median discount for the first quintile is 4.9%, compared to 51.0% for the fifth quintile. We observe the following from the quintile analysis:

• The median market capitalization declines steadily from $115 million (Q1) to $25.4 million (Q5). Restricted stock discounts tend to be negatively correlated to issuer size, as measured by market capitalization.
• There is no similar correlation with size, as measured by revenues, but median revenue was only $12.8 million.
• Median book value for the two-year sample was $7.0 million, and the median for total assets was $15.6 million.
• The median company in every quintile is losing money. Only 98 companies of the 248 observations in the pre-1997 study were profitable, meaning that some 60% of the transactions involved companies that were losing money.
• Median EBITDA is negative for the overall sample.
• The median dividend yield is 0% for each quintile.

The companies in the two year portion are quite small by current or then public market standards (median revenues of $12.8 million). The median price/book multiple was 5.8x, indicating that a significant portion of the value of the issuing companies consisted of goodwill and other intangible assets.

The bottom line of this analysis is that the two year study comprises fairly small, money-losing companies to which the market was assigning significant speculative, intangible value. This investment profile is not typical of most private companies that are the subject of valuation reports in 2022.

Observation 4 – Dissimilar Operating Characteristics. This more detailed quintile analysis of the FMV/Stout database suggests that typical transactions in the study are not similar to many private companies being valued today. This observation is based on my personal experience, familiarity with Mercer Capital’s broader business, and opportunities to review hundreds of reports prepared by other appraisers over the years. The issuing companies issuing restricted stock in the pre-1997 era were small, speculative (high price/book multiples), losing money,  and would have only limited usefulness as guideline transactions for appraisals performed currently.

Concluding Comments

We made four observations from this review of the 2004 FMV/Stout Database and repeat them now.

Observation 1 – Lack of Timeliness. It would seem that the use of transactions from the FMV Study as direct guideline company or guideline transaction observations of transactions occurring 25 or more years ago would not meet the customary standard of proximity to the valuation date for appraisals as of the current date.

Observation 2 – Limited Industry Representation. There is little industry diversification reflected by the companies involved with either portion of the FMV/Stout Database. This fact limits the usefulness of this restricted stock database as a vehicle to develop guideline transactions that are similar to given subject private companies in terms of industry.

Observation 3 – Observed Discounts Carry no Economic Information. The averages and medians of the FMV/Stout Study are just that – averages and medians. They convey no economic information at all, as explained in a prior series on restricted stock discounts in RSD-1: Background on Restricted Stock Discounts.

Observation 4 – Dissimilar Operating Characteristics. This more detailed quintile analysis of the FMV/Stout database suggests that typical transactions in the study are not similar to many private companies being valued today. This observation is based on my experience, familiarity with Mercer Capital’s broader business, and opportunities to review hundreds of reports prepared by other appraisers over the years. The issuing companies issuing restricted stock in the pre-1997 era were small, speculative (high price/book multiples), losing money,  and would have only limited usefulness as guideline transactions for appraisals performed currently.

The issuers of restricted stock were all (or virtually so) operating companies. Let me end with a question. How can these restricted stock transactions be used as guideline comparisons for valuing interests in asset holding entities? Perhaps we will address this question in more detail in a future post on this blog.

As always, please feel free to comment on this post.

Be well,

Chris